SPACs, Reverse Mergers, and Registered Direct Listings
An alternative public offering can allow companies to raise capital and go public without going through the traditional initial public offering. In an alternative public offering, a special purpose acquisition company (SPAC) is formed to acquire the target company the two key elements are a reverse merger and a special purpose acquisition company (SPAC).
A company’s acquisition through a special purpose acquisition company (SPAC) is similar to a standard reverse merger, in that both events cause the company to “go public.” SPACs typically raise more money through their initial public offering (IPO) than any money raised in standard reverse mergers. A registered direct listing is a process by which a company can go public by selling existing shares (typically held by existing selling shareholders) instead of offering new shares of the company. Further, companies that choose to go public using the direct listing method usually have different goals than those that are acquired by a SPAC, engage in a reverse merger, or undertake an underwritten IPO.1
SPACs
A SPAC is a shell company that has no operations but goes public through an IPO with the intention of acquiring or merging with another company by using the proceeds of the SPAC's IPO and the vision and experience of its management founders. SPACs allow retail investors to invest in private equity type transactions which are particularly akin to leveraged buyouts. Effectively, a SPAC is created specifically to pool funds in order to finance a merger or acquisition opportunity within a set timeframe. The acquisition opportunity usually is not yet identified at the time of its IPO.2
SPACs historically have been typically sold to the public in $6.00 units consisting of one common share and one or two "in the money" warrants to purchase common shares at $5.00 (a share) at a future date usually within four years of the offering. Today, a new generation of SPAC offerings are more commonly sold in $10.00 units of one common share and an "out of the money" warrant or fraction thereof. SPACs trade as units and/or as separate common shares and warrants on the national exchanges (e.g., Nasdaq and NYSE) once the public offering has been declared effective by the SEC. In addition, the public currency enhances the position of the SPAC when negotiating a business combination with a potential merger or acquisition target. SPACs often consummate these transactions through a reverse merger or other business combination.
Reverse Mergers
Reverse mergers are also commonly referred to as reverse takeovers or reverse IPOs. A reverse merger is a way for private companies to go public, and while they can be an excellent opportunity for investors, they also have certain disadvantages for investors as well. Reverse mergers typically occur through a simpler, shorter, and a less expensive and rigorous process than a conventional IPO. With an IPO, private companies must hire an investment bank, auditors, legal counsel, and other professionals to complete the sale of shares of the soon to be public entity.
In an IPO, aside from filing and engaging in the regulatory process with the SEC, and helping authorities review the proposed capital raise, the investment bank also helps to establish interest in the stock and provide advice on appropriate initial pricing. The traditional IPO necessarily combines the go-public process with the capital-raising function. A reverse merger separates these two functions, making it an attractive strategic option for corporate managers and investors alike.
In a reverse merger, investors of the private company acquire a majority of the shares of a public shell company, which is then combined with the purchasing private entity. Investment banks and financial institutions typically use shell companies as vehicles to complete these transactions. These simple shell companies are often listed on an exchange without enduring the rigors associated with conducting an underwritten offering, spin-off, or similar transaction.
Registered Direct Listings
Companies may also pursue a direct listing to provide liquidity and a broader trading market for its shareholders; however, the listing company can also benefit. Forecasting a direct listing may make the listing company’s equity more attractive to potential investors while the company is still private and provide greater process control to the company as it goes public.3 In addition, equity that will be publicly traded can serve as a more attractive acquisition currency, both before and after listing. Most significantly, however, listing provides a company with the option to use the public markets to raise cash (either immediately or at a later date), typically lowering its cost of capital and increasing flexibility in capital planning. Furthermore, a direct listing can save money by allowing companies to avoid underwriting discounts and commissions on the shares sold in an IPO.4
However, the direct listing regulatory process is similar to an underwritten IPO. A Form S-1 registration statement is filed with, and reviewed and declared effective by, the SEC. Existing shareholders, such as employees and early-stage investors, whose shares are registered for resale under this registration statement, are then able to sell their shares on the applicable exchange providing flexibility and value to such shareholders by creating a public market and liquidity for the company’s stock. Upon the listing of the company’s stock, the company becomes subject to the financial reporting and disclosure requirements applicable to all publicly traded companies, including periodic reporting requirements under the Securities Exchange Act of 1934, as amended, and governance and auditing requirements of the applicable exchange.
The Start-Up Company Example
Raising Capital
A startup business can finance its operations through private arrangements with individual investors, venture capital firms, and alliances with larger corporations. If the business owners wish to raise capital to finance future growth or to pay off debt, they may need to go to the existing shareholders who may be unwilling or unable provide more funding. By going public (becoming publicly traded) the company must now disclose full financial information about itself and submit itself to be regulated by the SEC. Outside investors are more willing to buy shares in a company whose growth prospects they can analyze. This, in turn, typically makes it easier for a company to raise capital.
Liquidity
By going public, a company provides liquidity for its shareholders. When a company grows, its major shareholders may wish to cash in on the wealth they have tied up in the business. The public offer creates a market for the company’s shares that gives investors the ability to sell their holdings. It also enhances the wealth of shareholders who can use the publicly traded stock as collateral for loans or other secured types of financing.
Valuation
Going public sets a market value for a company’s shares. They are only worth as much as someone is prepared to pay for them. Key employees with stock options that are part of their remuneration package are able to calculate their worth. The valuation of privately held companies, on the other hand, sometimes can be an over exaggerated presentation due to the lack of transparent financial information that the SEC requires in companies that are public.
Tax Concerns
Utilizing a company’s stock for acquisitions typically lowers the need for immediate cash, instead allowing businesses to complete a transaction without using working capital proceeds for continued growth and envisioned goals. Acquisitions made with stocks as consideration in payment may be seen as "tax-free" reorganizing, allowing the business to defer the tax on any gains from the business sale to a later date (when tax treatment may be more advantageous).
Grant of Options
A public company can also use its stocks to compensate existing and future employees and officers via directly issuing stock or stock options. This allows potential employees and management the opportunity to benefit from a business's success. There are several ways to structure the manner in which stock options are issued to such persons (e.g., an ESOP or other option plans). Indeed, in order to provide the liquidity for the sale of the shares underlying the options issued to such employees a public company will file a registration statement on Form S-8 covering those shares.
Disadvantages of Being a Public Company
While we have discussed the advantages of being a public company, there are certain disadvantages as well. There are many formal legal requirements associated with creating a publicly owned company. For example, a company listed on a national exchange will be required to meet the many governance and financial accounting demands of the Sarbanes-Oxley Act of 2002.5 Also, the company will be required to file quarterly and annual reports with the SEC, as well as annual proxy statements and other current reports.6 The financial costs associated with this new stature, the scrutiny of the public markets and the SEC, the amount of time required to prepare these reports, and compliance with SEC rules and regulations is also significant while a company's management team works on the business itself and also establishing the company’s new public identity.
Conclusion
As discussed above, the are many ways that a private company can go public without both the financial and time expenses involved in a traditional IPO. The prestige and value of being a public company may cause many private companies to seek alternative methods in attaining this goal. In this pursuit, a company should seek experienced and thoughtful legal counsel to assist it in assessing its options and finding and guiding it through any of the paths ultimately chosen.
This memorandum is a summary of the topics discussed above and does not purport to provide legal advice. No legal or business action should be based upon the above summary.
1 The major difference between a direct listing and an IPO is that one sells existing shares, while in an IPO the company issues new shares. In a direct listing, employees and investors sell their existing shares to the public. In an IPO, a company sells a part of the company by issuing new shares in order to raise capital. The goal of companies that become public through a direct listing is not focused on raising additional capital, which is why new shares of the company are not necessary.
2 The SEC has taken the position that if the SPAC, before the time if it’s IPO, has already settled on a target, then what may be occurring is not an IPO of the SPAC, but rather an IPO of the target itself. If that were true, then the IPO of the target would have to provide all the disclosure required in an IPO registration statement (financial disclosures, business discussions, and many other items).
3 For instance, the traditional roadshow has been replaced in some direct listings by an “investor day” where the company invites investors to learn about it in a manner that they have tailored themselves for the purpose of presenting and displaying the company’s best attributes.
4 However, the company will still incur significant fees to market makers or specialists, as applicable, independent valuation agents, auditors, legal counsel, and a financial advisor.
5 Companies whose shares are quoted in the over-the-counter market (“OTC”), however, are not required to comply with the same national securities exchange rules as are NYSE and Nasdaq traded companies. 6 For example, the company with file quarterly and annual reports on Forms 10-Q and 10-K, respectively. Also, it will be required to file a Current Report on Form 8-K when certain events occur (e.g.., entry into or termination of a material agreement, departure of directors and certain executive officers, sale of unregistered securities) describing the occurrence (and attaching any necessary exhibits) within four (4) business days of the event.